A hedge is never the exact inverse of what it hedges. A futures contract is standardised — one location, one grade, one month — while your exposure is specific, and the gap between the two is basis. This article explains what basis is, where it comes from, and why it survives a correctly sized hedge.
A hedge is supposed to be the mirror image of a position — the thing you add so that whatever the market does to one side, it does the opposite to the other. It never is. A futures contract is a standardised instrument, pinned to one delivery point, one grade and one month. Your exposure is a specific cargo, at a specific place, priced over a specific window. Between the two sits a gap called basis, and basis moves on its own. So a correctly sized, correctly timed hedge does not cancel your risk; it exchanges one risk for another, and the one it leaves behind is the one the position report does not show.
This article sets out what basis is, where it comes from, why it is the part of a hedge that remains after everything else has been done right, and why it tends to surface first as a profit-and-loss movement nobody can explain. It is written for the people who own the consequence of that gap: the traders and treasury desks who put hedges on, the middle office who measure whether they worked, and the risk function who have to explain, to someone above them, why a flat book still moved.
If you want the mechanism, start with A hedge is a different instrument from the thing it hedges. If you already hedge physical positions and want the part that fails silently, start with Why the report shows none of it.
A hedge is a different instrument from the thing it hedges
A futures contract is standardised — one delivery point, one grade, one month — and your position is specific, so the two can only move together approximately, never exactly.
The idea of hedging comes from the simplest case: you hold something whose price can move, and you take a position in an instrument whose price moves the other way. If the two moved in perfect lockstep, the hedge would be exact, and the story would end there.
They do not. The instrument you can hedge with is not a copy of the thing you hold. A futures contract specifies a single delivery location, a single deliverable grade or quality, and a single expiry month. Your position is a particular parcel, at a particular place, over a particular pricing window. Those are different in at least one dimension, and usually in several.
The consequence is that "hedged" never means "the price can no longer move against me". It means "the dominant price move has been removed, and what remains is the difference between the two prices". That difference is what this article is about.
The difference has a name, and it is priced every day: basis
Basis is the gap between the cash price of the thing you hold and the price of the futures contract you hedge it with, and that gap changes.
Basis is conventionally written as the cash price minus the futures price. When you buy a physical cargo and sell futures against it, you have fixed the futures leg of the trade. The cash leg is whatever the cargo will actually fetch or cost when you come to buy or sell it. If the two prices moved together perfectly, the basis would be constant and your result would be settled the moment you put the hedge on.
It is not constant. The cash price and the futures price are both driven by supply and demand, but by supply and demand in two different markets — one for a specific physical parcel, the other for a standardised contract traded by people who may never intend to take delivery. There is no reason they should move together in lockstep, and they do not.
So a hedge locks one of the two prices and leaves the other open. What is left open is not a detail; it is the entire difference between the result you planned and the result you get. Basis is the part of a hedge that is still a position after the hedge is on.
Basis comes from the ways a futures contract is standardised
Each way a futures contract is standardised is a place where it can stop matching your exposure, and each is a separate source of basis.
Three are ordinary.
Location. The contract delivers at a designated point or a small set of them. Your cargo loads, stores or sells somewhere else. Freight and regional supply and demand differ between the two places, and the difference moves. Hedging a cargo at one port with a contract priced at another leaves you exposed to the freight and the regional balance between them.
Grade and quality. The contract specifies a deliverable grade or a basket of grades with adjustments. Your parcel is a specific grade, often with its own assay, its own impurities, its own yield. What the contract's grade is worth relative to yours is itself a market, and it moves.
For physical crude, the grade differential is the largest part of this gap, and it is the part that survives even a correctly placed futures hedge. Crude Oil Trading: Why the Barrel You Hedge Is Not the Barrel You Own
Time. The contract expires in a specific month. Your exposure is priced over a window that may straddle months, sit at the end of one, or move when a vessel moves. The price of the contract and the price of your window are two different things even when they are adjacent, because the market for a given month moves on its own supply and demand.
None of these is exotic, and none of them is avoidable by being careful. They are the price of hedging with an instrument that is liquid precisely because it is standardised. The standardisation that makes the hedge cheap is the same thing that makes it imperfect.
Cross-hedging is hedging with a stand-in, and it carries the largest basis of all
When there is no liquid contract for exactly what you hold, you hedge with the closest thing, and the distance between the two is basis risk at its widest.
For many positions there is no contract that matches at all. A jet fuel book may be hedged with crude or gasoil. A regional power exposure may be hedged with a fuel or a broader index. A grade with no futures market is hedged against a related grade that has one. This is cross-hedging, and it is the most common kind of hedge in practice.
A cross-hedge rests on a relationship rather than on an identity. The two prices are not the same thing; they are two things that have moved together in the past, to a degree somebody measured at some point. The hedge works exactly as long as that relationship holds, and it stops working the moment it does not — which tends to be the moment the market is under stress and the hedge was most needed.
There is no way around this. The alternative to a cross-hedge is usually no hedge at all. But it is worth being precise about what has been done: a cross-hedge is a bet that a historical relationship will keep holding, wearing the clothes of a hedge. The relationship has to be watched, because the position report will not watch it for you.
A hedge does not remove risk; it exchanges one risk for another
Putting on a hedge converts an absolute price exposure into a relative one, and the relative one is smaller on average but not zero, and not steady.
This is the single most useful way to think about it. Before you hedge, your result moves with the level of the price. After you hedge, your result moves with the difference between two prices. Usually that difference is smaller and calmer than the level itself, which is why hedging is worth doing. But it is a different risk with different drivers, and it cannot be assumed away.
Two things follow.
The hedge is not finished when it is placed; it has to be managed through to the end. Because basis changes over the life of the hedge, the person who puts it on has to decide, at each step, whether the relationship it rests on still holds and whether the hedge still matches the exposure it was taken against. A hedge left unattended is a position that nobody is measuring.
And a "flat" book is not a "no risk" book. Flat means the hedge and the exposure offset in size and direction. It does not mean the basis has gone to zero. The residual that remains after a correct hedge is still a position, and it is the one the report least often shows.
The report shows the hedge, and the basis does not appear anywhere on it
A position report distinguishes hedged from unhedged, not matched from unmatched, and basis lives entirely in the second distinction.
When a position is hedged, the report typically shows the exposure and the hedge together, netting to something small. That is correct as far as it goes, and it is also the problem: the netted line looks finished. Nothing on it says how well the hedge matches the exposure, how far the two prices have drifted apart, or whether the relationship the hedge rests on was ever measured and when.
The information that would reveal basis is not hidden in a complicated model. It is simply not captured. The hedge and the exposure may sit in different systems, or in the same system with no field linking them as a pair. The basis — the difference between the two prices, and its history — is computed nowhere by default. It exists in the head of the person who put the trade on.
This is not a criticism of anyone's process; it is where the work runs. The step whose job is to measure whether a hedge worked is among the most spreadsheet-dependent in the whole trade lifecycle, and it carries some of the highest error cost. The consequence is familiar to anyone who has run a hedged book. The hedge is on, the size is right, the timing is right, and the profit and loss still moves — and the first person to notice is the one reading the report at month-end, not the one who could have acted on it.
Basis surfaces first as a profit-and-loss movement nobody can explain
The signature of basis risk is a correctly executed hedge whose result keeps drifting for reasons that are not on any report.
This is what makes basis risk harder to catch than the risks it replaces. An unhedged position announces itself: the price moves, the result moves, everyone sees it. A wrong hedge announces itself too: the sizes do not match, the dates are wrong, somebody finds it quickly. But a correct hedge with a large basis risk announces nothing. It looks, on the report, like a job done well.
The drift only becomes visible in hindsight. A cargo hedged at one location settles with a freight and regional basis that moved over the holding period. A cross-hedged grade stops tracking the instrument it was hedged with. The result comes in away from the plan, and the explanation is found later, in a relationship that was never stored anywhere.
The general shape is worth one line, because it applies to the whole subject: a hedge is a bet on a relationship, and the relationship is the part that is not on the report. Whether it still holds is a question that has to be asked on purpose, on a schedule, by someone whose job it is.
Four ways a hedge can miss its exposure
| Source | What it is | What makes it move | What the report shows instead |
|---|---|---|---|
| Location basis | The contract delivers at one point, your cargo is at another | Freight and the regional balance between the two places | A cargo marked hedged, with the location difference nowhere on the line |
| Grade and quality basis | The contract names a grade, yours has its own assay and yield | What the contract's grade is worth relative to yours | A physical position at one price, with no field for the quality spread |
| Time basis | The contract expires in a month, your exposure prices over a window | The month's own supply and demand, and any movement of the window | A hedge dated to a month, next to an exposure dated to a window |
| Cross-commodity basis | No matching contract exists, so you hedge with a related instrument | Whether the historical relationship between the two still holds | A hedge that looks complete, resting on a relationship recorded nowhere |
The bottom row is the one to sit with. It is the only one where the basis does not even have a standardised contract behind it, and it is the one an ordinary report most easily reads as a hedge that is simply done.
What a hedge record has to carry before anyone can see its basis
| Field | Why it is load-bearing |
|---|---|
| The instrument hedged with, and its contract specification (location, grade, month) | The basis is the difference between this and the exposure, so both sides must be named before the gap can be computed |
| The exposure it was taken against, in the same dimensions | A hedge without its matching exposure cannot be checked for fit |
| The relationship the hedge rests on, if it is a cross-hedge | A cross-hedge is a bet on a relationship; unnamed, it cannot be watched |
| When that relationship was last tested against what actually happened | An untested relationship is an assumption with a date on it, and the date is the useful part |
| The basis at the time the hedge was placed, and its history since | The whole of the residual risk is the movement of this number |
| Who is told when the basis moves beyond the range the hedge was sized for | Otherwise the answer is nobody, and the discovery happens at month-end |
A hedge record carrying these fields can be read by someone who was not there when the trade was put on. A hedge record carrying none of them can only be explained by the person who put it on — which works, until they are on leave and the market has moved.
Questions people ask about this
What exactly is basis, in one sentence?
It is the difference between the cash price of the thing you hold and the price of the futures contract you use to hedge it. When the two move together perfectly, the basis is constant and the hedge is exact; when they drift apart, the basis has moved and your result moves with it. The word is used for any gap of this kind, in every commodity.
If we hedge every position, why does our profit and loss still move?
Because a hedge removes the level of the price, not the difference between two prices. What is left after a correct hedge is the basis, and basis moves on its own drivers — freight, regional balances, grade spreads, the shape of a month. The report shows the hedge and the exposure netting to something small, so the residual movement has no obvious cause on the page.
Is basis the same thing as a differential?
They are close cousins but not the same object. A differential is usually the price of a grade or a location relative to a benchmark, inside the physical market. Basis is the gap between a cash price and a futures price, across the hedge. A differential can sit inside the basis. In crude, the grade-to-benchmark differential is one species of the gap; the futures-to-cash gap is another.
We hedge jet fuel with crude. Is that a hedge?
It is a hedge of a kind — a cross-hedge — and it works as long as the relationship between jet fuel and crude holds. The word to keep in front of it is "cross". A cross-hedge does not remove the risk of the spread between the two; it concentrates your exposure in that spread. That can be a sensible trade-off when the alternative is being unhedged, but it should be called what it is.
How do we know whether our hedge is actually working?
Measure the basis and its history, not just the hedge's presence. A hedge that is the right size and the right date can still be a poor hedge if the relationship behind it has weakened. The test is whether the two prices still move together to the degree they did when the hedge was sized. If nobody is measuring that, then nobody knows whether the hedge is working until the result comes in.
Why does the report say we are flat when we are clearly not?
Because "flat" on a position report means the hedge and the exposure offset in size and direction. It does not mean the basis has gone to zero. The basis is a separate number, and unless the report has a field for it and its history, it will not appear at all. Flat is a statement about quantities, not about the relationship between the two prices.
Where should we start if we have never looked at basis?
Start by pairing each hedge with the exposure it was taken against, and record two things for each pair: the instrument's contract specification, and the relationship the hedge rests on, if any. From there, compute the basis at the time the hedge was placed and track it forward. Almost everything else in this article becomes answerable once that pairing exists.
Can we eliminate basis risk entirely?
Only by not hedging, which replaces it with a larger risk — or by holding the exact deliverable grade at the exact delivery point for the exact delivery month, and even then the cash and futures prices can diverge for reasons of their own. The practical goal is not elimination; it is to know the size of the residual, watch it, and decide whether it is acceptable. Basis that is measured is a risk you manage; basis that is invisible is a risk that manages you.
Where this lands in a trading system
Nothing above is an argument for buying software. It is an argument about which facts a hedge's basis is made of, and where each of them first exists. Parts of it map onto system capabilities, and parts of it do not.
The first conclusion is that a hedge and the exposure it was taken against have to be held together, as a pair, before their basis can be computed at all. That is the job of a CTRM/ETRM system providing complete trading lifecycle management for commodity traders, integrating physical trade, financial hedging, risk control, and settlement in one platform; Time Dynamics' Fusion is one, and the parts of it that bear on this article are that complete physical trade lifecycle management and execution and advanced trading management for futures and derivatives markets sit in the same place, with comprehensive risk assessment and monitoring capabilities applied across both. The pairing is the precondition; the basis is then a difference between two things the system can already see.
The second conclusion is that the facts which tell you whether a hedge still fits — the freight and regional spreads, the grade relationship, the month's shape, the history of a cross-hedge's relationship — mostly arrive from outside the trading desk. That is what X-Ray is for: a non-invasive data processing and analysis platform, whose collection toolkit XDK performs non-invasive automated data collection from databases, Excel files, and web interfaces, and which is built to collect data without disrupting existing systems or workflows. The last property is the relevant one, because the spreadsheets holding your hedge pairings and basis history are working, and a plan that begins by taking them away from the person who maintains them will not survive the first basis move.
The third conclusion is that a cross-hedge rests on a relationship, and a relationship that is never tested against what actually happened is an assumption with a date on it. X-BT is a Python-based model development and backtesting environment with VSCode integration, and Feynman Language is a custom programming language for time series data visualization and processing. Whether either is pointed at a hedge relationship rather than at a trading model is a configuration question rather than something a platform decides for you — but testing whether two prices still move together is an ordinary shape, not an exotic one.
The fourth conclusion is that the same hedge has to be read as a pair — exposure, instrument, basis, history — and that view is the one most often rebuilt by hand. X-Sheet does one-click generation of personalized reports with Excel-like interface.
And here is where it stops. None of this decides what to hedge with, and none of it decides how much basis to accept. It will not tell you whether a cross-hedge's relationship is about to break, it cannot choose a delivery point or a grade for you, and it does not make a futures contract deliver at your terminal. It can test a relationship only if a person decides which relationship, against what, and how often — and that is judgement, not configuration. What a system can settle is narrower and duller than the problem in this article: where each hedge's basis is captured, how soon after it moves, and whether the person who needs to see it can do so without asking the person who put the trade on. That is a real part of the gap. It is not the whole of it, and it is worth being clear about which part you are buying.
The hedge is not the problem. The gap it leaves behind is.
A note on the evidence in this article
This article contains no statistics, and that is deliberate. The observations behind it — that hedges are standardised instruments while exposures are specific, that the difference between the two moves on its own drivers, and that the difference is rarely stored — come from material we are not in a position to publish as a citable figure. A number nobody could check would make the argument look stronger and would make it worth less.
So the argument runs on mechanism, and each claim is written to be tested against your own book rather than taken on our authority. Three tests are proposed above and they are the intended use: pair every hedge with the exposure it was taken against and compute the basis at placement; measure whether each cross-hedge's relationship still holds against what has actually happened; and ask, of any "flat" line, what number represents the gap between the two prices and whether anyone is watching it. If your own book contradicts what is written here, your book is the better evidence.